Christopher William, president of William Industries which produces widgets, has

Question

Christopher William, president of William Industries which produces widgets, has hired you to determine its cost of debt and the cost of equity capital. The stock currently sells for $25 per share and the dividend will be $5. Christopher argues that it will cost us $5 per share to use the stockholders money this year therefore the cost of equity is equal to 20%. Furthermore, Christopher believes that the cost of debt is 25%. This is based upon the most recent financial statements which show that William Industries has total liabilities of $10 million and will face total interest expenses for the year of $2.5 million. Christopher argues that the company should increase its use of equity financing because debt costs 25% while equity only costs 20% and thus equity is cheaper. Is Christopher’s analysis of the cost of equity, debt, and decision to increase the use of equity financing over debt financing accurate?

Explanation / Answer

Christopher has not taken the tax deduction due to interest expense into consideration. If the tax deduction is taken into account then the cost of debt would be further moderated and might lead to change the decision of capital funding going forward. Therefore, the decision to increase use of equity capital over debt financing is not accurate in a world where earning is subject to taxation.

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